Nuclear Default

Posted on October 15, 2013

“It should be like nuclear bombs, basically too horrible to use.” - Warren Buffett on politicizing the debt ceiling

We wrote about The 95th Raising Of The Debt Ceiling back in January of this year. By way of review, the debt ceiling was introduced in 1917 when Congress delegated the responsibility for issuing government bonds to the US Treasury. Prior to that point, every single bond issuance was debated and voted on individually. This process became too onerous when the country entered the first world war, causing Congress to empower the US Treasury to issue debt without congressional approval. This authority was subject to the caveat that Congress could set a limit on the total amount of debt outstanding.

In practice, the debt ceiling is more a symbolic formality than it is an actual mechanism for accountability. After all, the US Treasury has no reason whatsoever to issue debt beyond what is needed to fund the spending that Congress itself approves. Therefore, despite the fact that Congress must go through the motions to authorize more debt, it has already given its implicit blessing for more debt by approving the deficit spending in the first place. Accordingly, raising the debt ceiling is a fairly standard procedure that usually occurs without much fanfare.

Historically, however, this hollow tradition has proven an effective tool in political bargaining. Politicians from both sides of the aisle have used the debt ceiling vote to apply pressure and extract concessions from the other side. One well-known example was in 1987 when Reagan was in office. The same form of “hostage-taking” that we are seeing today was implemented by a group of congressman set on attaching deficit reduction measures to the debt ceiling increase.

“To play around with the debt limit this way means really that you’re playing with dynamite. There is a gun to the president’s head.” – Treasury Secretary James Baker, 1987

After some resistance Reagan eventually gave in and granted some concessions in order to avoid a disorderly default, but not without chastising Congress for using the debt limit in such a fashion, saying “Congress consistently brings the government to the edge of default before facing its responsibility.” One notable difference between 1987 and today is that the political maneuvering was truly a bi-partisan effort. Just imagine…democrats and republicans working together for a common cause!

Another well-known example of debt ceiling shenanigans occurred in the mid-90’s when Newt Gingrich led a hardline effort to attach a balanced budget amendment to the debt ceiling extension. After a battle lasting several months and a prolonged government shutdown, congressional republicans finally backed off their strictest demands and President Clinton signed an increase that carried with it only a handful of additional provisions.

Even our current President has a history of standing in opposition to increasing the debt ceiling. In early 2006, in the midst of the Iraq War, senator Obama (along with every other Democrat on the floor) voted against the debt ceiling measure that was being brought by senate republicans. There was absolutely nothing additional attached to that proposal. Five years later, as president, Obama looked back on that vote with regret in an interview with ABC, saying,

As president, you start realizing, 'You know what? We can't play around with this stuff. This is the full faith and credit of the United States.’ So that was just an example of a new senator, you know, making what is a political vote as opposed to doing what was important for the country. And I'm the first one to acknowledge it.

The historical record clearly shows that the politicization of the debt ceiling that we are seeing today is nothing new. That said, we are closer to an actual default today than we have been in the past, and the chasm separating democrats and republicans on this issue has caused nearly the entire globe to begin asking tough questions. What would happen if the US government didn’t have enough cash on hand to pay its bills? Who would get paid and who would be left out to dry? Is the global economic recovery at risk? A US default…what does that even mean?

To be fair, no one really knows the answers to these questions as an actual default would be unchartered territory for the US. In 1979 we experienced a “technical default” when the Treasury was delayed in making some t-bill payments due to a computer glitch. Even though that event was a mistake and very short lived, it caused yields to spike and remain elevated for months. What if the US deliberately did not make an interest payment on its bonds? Some believe the ensuing financial catastrophe would make the Lehman Brothers collapse look like child’s play. From an article published by Bloomberg earlier this month:

Failure by the world’s largest borrower to pay its debt -- unprecedented in modern history -- will devastate stock markets from Brazil to Zurich, halt a $5 trillion lending mechanism for investors who rely on Treasuries, blow up borrowing costs for billions of people and companies, ravage the dollar and throw the U.S. and world economies into a recession that probably would become a depression. Among the dozens of money managers, economists, bankers, traders and former government officials interviewed for this story, few view a U.S. default as anything but a financial apocalypse.

At first glance it might be easy to write off such a doomsday prediction. After all, it’s important to distinguish between an inability to pay and an unwillingness to pay. A US default in this case would clearly be the latter. As such, we are inclined to ask, “What’s the big deal?” Even if the US temporarily has to delay payments on its obligations, surely that will be a short-lived event and creditors will be made whole as soon as a resolution is reached in Washington. Not to mention the fact that the US Treasury continues to receive tax revenues that cover the majority of obligations under the federal budget.

While all that is true, we need to peel back a layer to understand the negative impact a US default, as temporary as it may be, would have on financial markets and the global economy. Beneath that layer we’d find the repo market. A repurchase agreement (“repo”) is a form of short-term collateralized borrowing that is utilized nearly across the board by institutional investors and Wall Street banks. A repo is entered into when an entity pledges a security as collateral to borrow funds, which are then invested in higher yielding assets. And guess what type of security is most commonly used as collateral in repo agreements – that’s right, US Treasuries. Put another way, nearly $3 trillion worth of US Treasury bonds are currently posted as collateral against leverage on the balance sheet of investment banks, hedge funds and other capital market participants. A default, technical or real, would immediately disqualify these securities from serving as collateral, triggering a viscous spiral of asset sales and deleveraging. Prices of all types of securities would collapse, as would confidence and economic activity. Sound familiar?

We believe a disaster of this magnitude will be averted. As the chart below suggests, there is no force so persuasive in triggering a debt limit increase than, well, running out of money.

Even as we pen this the headlines are streaming in suggesting Congress and the White House are nearing a deal. Additionally, there is more time than most people think before an actual debt default might occur. Treasury has indicated that its borrowing authority will be used up by Thursday of this week, but even then it will not be until later this month that cash on hand is fully exhausted. And finally, even in the absence of new borrowing the government may be able to prioritize its payments to ensure that interest and principal continue to be paid on treasury securities at the expense of lower priority invoices such as government contractors and federal salaries. With the financial crisis still fresh on most policymakers’ minds, and ample warning from Wall Street and business executives about the potentially nuclear impact of a debt default, we simply find it hard to believe that the collective intelligence in Washington could fall short of what is needed to avoid the worst case scenario.

Even so, the predicament in Washington has become a losing proposition for the full faith and credit of the United States - regardless of the outcome. Richard Bernstein described it this way,

Auto insurance seems to provide an appropriate analogy to the situation now faced in Washington. Suppose one has an impeccable driving record, but unfortunately one day gets into an auto accident. Will the auto insurance company raise or lower one’s insurance rates? Of course, the insurance company will raise the premium. One doesn’t know how much the insurance premium will go up, but one can be fully certain that it will not go down.

For a country that is so reliant on an attractive cost of capital to fund its government and financial markets, wrestling so close to the brink is going to do nothing but increase speculation that eventually you will fall off the cliff. Higher marginal interest rates, unfortunately, could be one of the lasting legacies left behind by all this political dysfunction.

We have been talking about this moment in our Weekly Insight for several months now (see A Dangerous Game Of Chicken and Dual Headed Policy Monster). We did not expect the impasse to be this protracted, but we fully expected the debate surrounding the budget and the debt ceiling to be a temporary source of uncertainty and fixation in the financial media. We, for now, are positioning portfolios with the expectation that today’s crisis is going to be yesterday’s news within a few weeks (if not days). This means sticking with our broadly diversified Diversification 2.0 allocation and closely watching MarketVANE for a sell signal in risk assets rather than running for the hills in fear of a worst case scenario that is highly unlikely to occur.

Author David Houle, CFA is a founding member of Season Investments. He serves as the firm's Chief Compliance Officer as well as sitting on the investment committee overseeing the management of client assets. David spent nearly ten years in various roles primarily managing individual client assets prior to co-founding Season Investments. David graduated with a degree in Finance from Colorado University in Colorado Springs in 2003 and earned the Chartered Financial Analyst (CFA) designation in 2006. David and his wife Mandy have three children and spend most of their free time with friends and family.

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